The ongoing malaise in the European financial-services sector is making it incumbent on banks to boost profitability if they are to regain the trust of the capital markets and present an attractive opportunity to investors. Banking leaders are struggling to find sustainable solutions that would enable their institutions to produce returns close to or greater than their cost of equity. Indeed, banks may be reaching a limit on the degree to which senior bankers can close their firm’s profitability gap on a stand-alone basis.
That, in part, is why we believe the industry is about to experience an increase in the sector’s M&A activity, which currently stands near 20-year lows. Banks will be looking to further rationalize their portfolios by divesting poorly performing businesses. They will seek to gain efficiency by merging with other institutions, and to boost growth by making strategic acquisitions. Their mergers and acquisitions strategies might include gaining new lines of business and new digital capabilities, grabbing market share in home markets, and, for some players, expanding into new, more profitable geographies, notably in developing economies.
Such deals are likely to fail, however, unless banks fully understand the entire range of economic factors and technical details involved in every potential deal. Key success factors include a deal’s commercial viability, the financial impact of executing the deal, and whether the deal will actually deliver the expected value over time. In particular, issues such as the combined entity’s customer base, “fair value” accounting for the banks’ combined assets, tax effects, harmonization of illiquid Level 3 assets and risk-weighted asset models, and impending litigation liabilities may seem like mere technicalities, but they can make or break the viability of any deal.
European institutions looking to fix their income statements and balance sheets through M&A have a relatively brief window in which to act, as the number of attractive targets is limited. So it is essential that they move fast, but do so wisely, paying careful attention to all the factors that ensure a deal’s success.
Given the many structural challenges banks in Europe are facing, we see clear evidence that the level of M&A activity in the sector will likely increase substantially — and soon. Many European banks, both potential acquirers and their targets, are already preparing — completing strategic turnaround efforts, managing high levels of nonperforming loans, and resolving pending litigation and compliance issues.
Any decision to enter into a deal, however, must be tempered by a full understanding of the financial impact it would have on the bank’s capitalization and valuation, including all aspects of transaction execution and value delivery. That understanding must also be seen in the light of an honest and detailed appraisal of the bank’s current status and future prospects as a stand-alone institution.
Increased profitability, the right capabilities, and a stronger competitive position are musts for every large European bank, and if done right, a merger or acquisition offers the promise of all three. But the number of suitable partners for each bank is going to be limited, so the most advantageous deals will go to those banks that are ready to take action sooner rather than later.